|STRATEGY #2: Summer Options Strategies - Laying out Covered Call and Put-Sale Ideas
By Chris Borgmeyer, CFA, Director of Live Analysis
This report lays out what we view to be several attractive options strategies for the summer. The market tends to see choppy trading conditions during the summer months. Additionally, the May sell-off in the market and ongoing uncertainty (Europe issues, China, impact on U.S.) has resulted in elevated volatility levels across the broader market. These elevated volatility levels make it more attractive to sell options, which can generate additional yield and help enter into positions in attractive equities. We lay out the following strategies for various options in the July-September time frame below:
calls on attractive dividend yield stocks.
While these two types of yield-generating strategies can be applied to any stock that has liquid options available to trade, we will look at applying the strategies to a few different groups of stocks.
For the covered call strategy, we present attractive covered call candidates on stocks that already have a healthy and safe dividend yield on their own.
For the put sale strategy, we highlight attractive contracts to sell on large-cap S&P 100 names, along with an different individual stock candidate and broad market ETFs.
I. Covered Call Candidates
The recent increase in volatility from the March lows makes covered calls a more attractive strategy for those looking to enhance yield on long stock positions. Instead of just scanning for attractive covered calls, we like the idea of selling calls against stocks that already have an attractive and safe dividend yield on their own, as these stocks may see less downside in the event of further broad market pressure and investors are increasingly demanding safe yield these days.
For those unfamiliar with the strategy, a covered call is an income generating option position that involves selling one call option for every 100 shares of underlying stock owned. The sale of the call option generates cash from the premium received on the sale of the option, which produces additional income and reduces the downside risk on the stock position. The drawback is that the sale of the call limits the available upside in the stock position, as it gives the call buyer the right to purchase the stock from the call seller at the strike price. It is a limited risk/limited profit strategy.
The strategy we envision here is selling an upside front-month call each month on the stocks highlighted below (one short call per 100 shares of long stock) to generate a healthy monthly yield on top of the already attractive dividend yield on the stocks. In addition to front-month candidates, we've included second-month options that would also represent attractive covered call candidates.
Thinking about the risks to this strategy, there are two sides to consider. If the stock makes a sharp move higher through the strike price, the upside on the stock position will be capped by the short call. The stock will either get called away at the strike price or the call will need to be bought back at a higher price to avoid the sale of the stock. The loss on the call position above the strike will be offset by the increase in the stock price, but this means the upside in the stock is capped at the strike price. In order to minimize the risk of getting called away, we focus on upside options strikes where that risk is estimated to be less than 35%. On the other hand, in the event that the stock moves sharply lower, the short call will partially offset long stock losses , but only to the extent of the premium received in the sale of the call.
The table below details attractive covered calls for the July expiration month.
These stocks have strong, healthy dividend yields on their own, and with the covered call premiums, could see a yield of 10%+.
Additional Covered Call Candidates for Aug.
Below is a list of attractive covered calls for the August expiration month, from the same universe of stocks with strong, healthy dividend yields on their own.
*Annualized premium based on 6 months of sales, rather than 12, since there are 2 months to expiration.
II. Put Sale Candidates
The spring sell-off in equities has made stocks
more attractive from a valuation standpoint, and equities in general continue to
present an attractive value relative to fixed income. This weakness in equities
is reflective of heightened uncertainty and risk perceptions, which are likely
to remain elevated over the near-term. Additionally, these same factors lead to
higher put prices. With the potential for choppy markets and heightened
volatility levels. selling puts are an attractive yield generator in stocks that
the put-seller is comfortable owning at the strike price.
The sale of puts can generate monthly income
and take the timing aspect out of entering into the stock position in the event
the stock expires below the strike price. The idea is to sell a downside put on
a monthly basis. If the stock is above the strike price at expiration, the put
will expire worthless and the seller keeps the entire premium received from the
sale of the put.
i. Selling puts on large-cap stocks (excluding banks):
First, we screened for attractive puts to sell on widely-held large-cap stocks. We excluded bank stocks due to their more significant exposure to an exogenous event out of Europe. We list the most attractive puts to sell on this universe below, along with the yield potential.
ii. Facebook (FB 32.00) idea:
FB has seen a nice rebound off of its post-IPO lows, but is still 16% its IPO price and its puts offer a decent sized premium. One can sell the July 29 puts for $0.60, and collect $60 per contract. As long as the stock is trading above the $29 strike at expiration, which is 9.5% below current levels, the puts will expire worthless. Based on current market prices, the puts have about a 75% chance of expiring worthless.
Looking out to August, the Aug $28 puts can be
sold for $1.40, to collect $140 per contract. As long as FB is trading above $28
at expiration the puts will expire worthless and the put seller pockets the full
premium received in the sale. The $28 level is 12.5% below current levels, and
the options market is pricing in a 75% of those puts expiring worthless.
iii. Broad market put sale:
The Fed stopped short of signalling additional QE at its last meeting, but did indicate it will be there to support markets, if needed. For longer-term investors, stocks are already attractive from a valuation standpoint. However, with slowing economic growth and a lot of uncertainty, the fundamental picture is cloudy at best. This situation can make it difficult to "pull the trigger" on new equity positions, and timing this market is very difficult.
For those comfortable getting long a diversified equity position via an index ETF, we like the idea of selling downside puts in such a diversified market index ETF, such as SPY or QQQ. This can be done on a monthly basis, and will pay off if the market chops sideways or drifts higher. The biggest risk is of a larger broad market meltdown from here, in which case the puts will inflate and short positions will see losses. However, for investors that are comfortable owning the broad market at lower prices, such a downturn would result in getting long the ETF at the strike price.
Looking at SPY, the July 127 puts can be sold for $1.18, with the put seller collecting $1.18 per contract. These puts have about a 1-in-4 chance of finishing in-the-money, in which case the put seller would need to buy 100 shares of SPY at the $127 strike price, or would need to buy back the put prior to expiration at a loss. This put sale strategy would get more attractive if stocks move lower and volatility rises further, so one could wait to implement the strategy on a bigger pullback.
-- Chris Borgmeyer, CFA
The Special Reports column can be found on the Trading Ideas/Fundamental home
This report should not be considered a comprehensive list of volatility
events -- there may be other scheduled or unscheduled events that represent
significant volatility catalysts that are not discussed here.